No End in Sight for Britain's Bank Rescue

The U.K. committed more money to rescuing banks during the credit crunch than on any project in British history outside of world wars. The cost keeps rising as the government continues to pay interest on money borrowed to fund bank takeovers.

Oct. 7 marks the second anniversary of the bailout, which was spurred by the concern of then-Chancellor of the Exchequer Alistair Darling that Royal Bank of Scotland, (RBS) the nation's second-largest bank, and HBOS, Britain's biggest mortgage lender, didn't have enough money to open their doors the next day. The government invested, lent, and pledged more than £850 billion ($1.33 trillion) to rescue stricken banks during the financial crisis that began in 2007, the National Audit Office, Britain's public spending watchdog, said in a December report. The government took an 83 percent stake in RBS, paying £45.5 billion, and agreed to insure £280 billion of its riskiest assets for an annual fee. It injected £20 billion into Lloyds Banking Group (LYG), which acquired HBOS, in exchange for a 41 percent stake. The U.K. provided an additional £450 billion in guarantees to increase bank liquidity.

While U.S., French, and Swiss banks have repaid their bailouts, Britain hasn't received any return on its investments in RBS and Lloyds, the country's third-largest lender. The annual interest payment on the bonds the government sold to pay for the rescue is about £3.2 billion, according to a JPMorgan Chase (JPM) estimate, adding to the cost of the bailout.

Struggling to trim a budget deficit, British officials would like to sell the nation's shares in the two banks, but the timing of any sale is complicated. For one thing, a government commission is studying whether to have all the country's banks separate their retail and investment banking businesses, and no sale is likely until the commission's work is done next September because the findings may affect the value of the banks, according to government officials who declined to be identified.

Selling now also would leave the government with little or no gain on its investments. RBS and Lloyds have been among the best-performing bank stocks in Europe and the U.S. this year after returning to profit earlier than analysts expected. As of Sept. 17 the U.K. had a £3.35 billion paper profit on its stake in London-based Lloyds, after the shares gained 49 percent this year, and a £1.87 billion loss on RBS, even after its shares rose 64 percent. Since the start of the financial crisis in August 2007, RBS stock has plunged 90 percent, and Lloyds shares have fallen 73 percent.

"The government investigation into separating the banks rules out any sale in the short term," says Jeremy Scott, the global financial-services chairman of PricewaterhouseCoopers, who wrote a report saying it may take up to seven years to sell the stakes. "The markets are not favorable at the moment, even if you wanted a sale."

British officials also would like to sell Northern Rock, which it took over in February 2008. The government is managing the mortgage loans of another bank, Bradford & Bingley, after its branches and deposits were sold to Spain's Banco Santander (STD) in 2008.

U.K. Financial Investments (UKFI), which manages the country's bank holdings, declined to comment on how much the bailout would cost or when share sales might begin. The government announced in June that it is planning a discount sale of bank shares to the public to foster what Prime Minister David Cameron termed "popular capitalism." It is also considering selling shares to institutional investors and using convertible bonds to dispose of the stakes, UKFI said in its annual report last year.

While Britain's decision to take direct stakes in banks exposes taxpayers to risk, the government stands to benefit from the rise in share prices if it is patient, according to Charles Davis, an economist at the Centre for Economics and Business Research in London. "Holding the banks for longer gives the government a better chance of reaping bigger profits," says Davis, whose firm estimates that British taxpayers stand to make about £19 billion from the rescue. "Banks are getting their balance sheets in order and should become increasingly profitable over the next few years."

The bottom line: By holding its shares in RBS and Lloyds, the U.K. may earn a profit. Meanwhile, the cost of carrying the stakes continues to rise.

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